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EU Green Taxonomy to Channel Capital to Sustainable Activities

The EU taxonomy of sustainable activities will enable regulators and investors to evaluate the sustainability of economic activities and direct investments into low-carbon transition, Fitch Ratings says, although it will impose complex disclosure requirements on corporates.

The taxonomy, a classification system establishing a list of environmentally sustainable economic activities, aims to reach the EU’s Green Deal’s objective of making the EU economy sustainable and informs a range of regulatory frameworks such as the Green Bond Standard and Sustainable Finance Disclosure Regulation for asset managers. A key date for corporates will be 1 January 2022, when the revised Non-Financial Reporting Directive (NFRD) is due to come into force for companies with more than 500 employees. The scope of reporting could be expanded to cover any large companies, regardless of the number of employees, as well as listed SMEs, as has been proposed in a provisional Corporate Sustainability Reporting Directive, published today.

Under the NFRD, companies will be required to report what share of their revenue, capital and operating expenditure is taxonomy-aligned. Eligible activities must contribute to one of the six environmental objectives: climate change mitigation; climate adaptation; protection of water and marine resources; transition to a circular economy; pollution prevention and control; and protection of healthy ecosystems. Science-based performance thresholds are included for more than 70 economic activities representing major sources of EU emissions, although some polluting activities, such as agriculture, have been omitted from the latest draft of the regulation and most thresholds focus on direct emissions rather than indirect or supply chain-related.

Activities that are ‘enabling’ in relation to the above-mentioned eligible activities or ‘transitional’ in relation to climate change are also eligible, provided they do ‘no significant harm’ to any of the six objectives. In practice, ‘no significant harm’ entails a qualitative assessment by disclosers and has been subject to some controversy. We previously highlighted the potential of a ’brown’ taxonomy to support climate risk mitigation in investment and negative screening remains the most widely applied investment strategy with regard to climate change.

Capex and opex can be included in the reported share if they intend to make an activity taxonomy-compliant within five years. For example, highly efficient steel production consistent with industry-leading emissions performance could be eligible, as could expenditures on low-carbon research and development. The Global Commission on the Economy and Climate has estimated that USD93 trillion of investment is needed in low-carbon technologies over the coming decade to meet the Paris Agreement targets, with access to capital for carbon-intensive industries becoming critical.

This flexibility, underlined in the European Securities and Markets Authority’s new disclosure recommendations for the NFRD, could be the most consequential aspect of the taxonomy given the low levels of full alignment across most activities. This could also fulfil huge financing needs for low-carbon transition in high-impact sectors, such as mining and transportation. Standardisation could also spur the growth of sustainability-linked debt issuances, which typically tie borrowers to quantified performance targets and have heighted scrutiny of corporate opex, capex and management plans with regard to emissions reduction.

Corporates and investors will also face the emergence of taxonomies in other countries, including Australia, Canada, China and Singapore. Those taxonomies may have different priorities such as substitution of coal with natural gas. Engagement between the EU, China and other countries is continuing through the International Platform on Sustainable Finance and we expect it to report in autumn 2021 on activities that are accepted as sustainable across regions, otherwise referred to as the “common ground taxonomy”. This could reduce the reporting burden for corporates and investors operating across geographies while acting as a benchmark from which regional considerations can be adapted.
Source: Fitch Ratings

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